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Chapter 24 Power Notes Capital Investment Analysis Learning Objectives 1. Nature of Capital Investment Analysis 2. Methods of Evaluating Capital Investment Proposals 3. Factors That Complicate Capital Investment Analysis 4. Capital Rationing C24 C24 - 1 Chapter 24 Power Notes Capital Investment Analysis Slide # Power Note Topics 3 • Nature of Capital Investment Decisions 7 • Average Rate of Return; Cash Payback 15 • The Time Value of Money 26 • Present Value Analysis 29 • Other Considerations Note: To select a topic, type the slide # and press Enter. C24 - 2 Nature of Capital Investment Decisions 1. Management plans, evaluates, and controls investments in fixed assets. 2. Capital investments involve a long-term commitment of funds. 3. Investments must earn a reasonable rate of return. 4. Should include a plan for encouraging and rewarding employees for submitting proposals. C24 - 3 Methods of Evaluating Capital Investments Methods that do not use present values Average rate of return method Cash payback method Methods that use present values Net present value method Internal rate of return method C24 - 4 Average Rate of Return Advantages: Disadvantages: Easy to calculate Ignores cash flows Considers accounting Ignores the time income (often used to value of money evaluate managers) Cash Payback Advantages: Disadvantages: Considers cash flows Ignores profitability Shows when funds (accounting income) are available for Ignores cash flows after reinvestment the payback period C24 - 5 Net Present Value Advantages: Disadvantages: Considers cash flows Assumes that cash and the time value of received can be money reinvested at the rate of return Internal Rate of Return Advantages: Disadvantages: Considers cash flows Requires complex and the time value of calculations money Assumes that cash can Ability to compare be reinvested at the projects of unequal size internal rate of return C24 - 6 Average Rate of Return Method Assumptions: Machine cost $500,000 Expected useful life 4 years Residual value none Expected total income $200,000 Estimated Average Average Rate Annual Income of Return = Average Investment C24 - 7 Average Rate of Return Method Assumptions: Machine cost $500,000 Expected useful life 4 years Residual value none Expected total income $200,000 Estimated Average Average Rate Annual Income of Return = Average Investment Average Rate $200,000 / 4 yrs. of Return = = 20% ($500,000 + $0) / 2 C24 - 8 Average Rate of Return Method Assumptions: Proposal A Proposal B Average annual income $30,000 $36,000 Average investment $120,000 $180,000 Average rate of return Estimated Average Average Rate Annual Income of Return = Average Investment What is the average rate of return for each proposal? C24 - 9 Average Rate of Return Method Assumptions: Proposal A Proposal B Average annual income $30,000 $36,000 Average investment $120,000 $180,000 Average rate of return 25% 20% This method emphasizes accounting income which is commonly used in evaluating management performance. C24 - 10 Cash Payback Method Assumptions: Investment cost $200,000 Expected useful life 8 years Expected annual net cash flows (equal) $40,000 Cash Total Investment Payback = Annual Net Period Cash Inflows What is the cash payback period? C24 - 11 Cash Payback Method Assumptions: Investment cost $200,000 Expected useful life 8 years Expected annual net cash flows (equal) $40,000 Cash Total Investment Payback = Annual Net Period Cash Inflows Cash $200,000 Payback = = 5 years $40,000 Period C24 - 12 Cash Payback Method Assumptions: Net Cash Cumulative Flow Net Cash Flow Year 1 $ 60,000 $ 60,000 Year 2 80,000 140,000 Year 3 105,000 245,000 Year 4 155,000 400,000 Year 5 100,000 500,000 Year 6 90,000 590,000 If the proposed investment is $400,000, what is the payback period? C24 - 13 Cash Payback Method Assumptions: Net Cash Cumulative Flow Net Cash Flow Year 1 $ 60,000 $ 60,000 Year 2 80,000 140,000 Year 3 105,000 245,000 Year 4 155,000 400,000 Year 5 100,000 500,000 Year 6 90,000 590,000 If the proposed investment is $450,000, what is the payback period? C24 - 14 The Time Value of Money – Future Value The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value $1,000 What is the future value of $1,000 invested today (present value) at 8% per year? Future $ ???? Value C24 - 15 The Time Value of Money – Future Value The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value $1,000 What is the future value of $1,000 invested today (present value) at 8% per year? Future = $1,000 + ($1,000 x 8%) $1,080 = $1,000 x 108% or 1.08 Value C24 - 16 The Time Value of Money – Present Value The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value $ ???? What is the present value of $1,000 to be received one year from today at 8% per year? Future $1,000 Value C24 - 17 The Time Value of Money – Present Value The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value $ 925.93 = $1,000 / 108% or 1.08 What is the present value of $1,000 to be received one year from today at 8% per year? Future $1,000 Value C24 - 18 Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present Value of $1 with Compound Interest PV Table Period 6% Calculator 1 .9434 = $1.0000 / 1.06 One dollar at the end of one period at 6% per period is equal to $.9434 today (present value). C24 - 19 Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present Value of $1 with Compound Interest PV Table Period 6% Calculator 1 .9434 = $1.0000 / 1.06 2 .8900 = $ .9434 / 1.06 One dollar at the end of two periods at 6% per period is equal to $.8900 today (present value). To use the value from the prior period as the starting point, don’t clear your calculator. C24 - 20 Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present Value of $1 with Compound Interest PV Table Period 6% Calculator 1 .9434 = $1.0000 / 1.06 2 .8900 = $ .9434 / 1.06 3 .8396 = $ .8900 / 1.06 One dollar at the end of three periods at 6% per period is equal to $.8396 today (present value). C24 - 21 Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present Value of $1 with Compound Interest PV Table Period 6% Calculator 1 .9434 = $1.0000 / 1.06 2 .8900 = $ .9434 / 1.06 3 .8396 = $ .8900 / 1.06 4 .7921 = $ .8396 / 1.06 5 a calculator,$learn to /use constant division. When using .7432 = .7921 1.06 and .7432 / first You will then enter $1 = $ 1.06 the1.06 time, pressing 6 .7050 only the equal (=) key for each successive answer. C24 - 22 Calculating Present Values of Annuities Annuities represent a series of equal amounts to be paid or received in the future over equal periods. Present Value of $1 — Annuity of 1$ PV Table Annuity Calculation Period 6% 6% Sum of Periods 1 .9434 .9434 = Period 1 2 .8900 1.8334 = Periods 1–2 .8396 2.6730 = to be 3 The PV of an annuity of $1Periods 1–3 .7921 year for = Periods 1–4 4 received each 3.4651 two years is of the PV of 5 $1.8334. This is the sum = Periods 1–5 .7432 4.2124 the two amounts for periods 1 and 2. 4.2124 C24 - 23 Calculating Present Values of Annuities Annuities represent a series of equal amounts to be paid or received in the future over equal periods. Present Value of $1 — Annuity of 1$ PV Table Annuity Calculation Period 6% 6% Sum of Periods 1 .9434 .9434 = Period 1 2 .8900 1.8334 = Periods 1–2 3 .8396 2.6730 = Periods 1–3 .7921 3.4651 = to be 4 The PV of an annuity of $1Periods 1–4 .7432 year for = Periods is 5 received each 4.2124 three years 1–5 $2.6730. This is the sum of the PV of 4.2124 the three amounts for periods 1–3. C24 - 24 Calculating Present Values of Annuities Annuities represent a series of equal amounts to be paid or received in the future over equal periods. Present Value of $1 — Annuity of 1$ PV Table Annuity Calculation Period 6% 6% Sum of Periods 1 .9434 .9434 = Period 1 2 .8900 1.8334 = Periods 1–2 3 .8396 2.6730 = Periods 1–3 4 .7921 3.4651 = Periods 1–4 5 .7473 4.2124 = Periods 1–5 Total 4.2124 C24 - 25 Present Value Method Assumptions: Investment $200,000 Useful life 5 years Residual value none Minimum rate of return 10% Cash Flow Present Value Year 1 $70,000 / 1.10 (1 time) = $ 63,636.36 Year 2 60,000 / 1.10 (2 times) = 49,586.78 Year 3 50,000 / 1.10 (3 times) = 37,565.74 Year 4 40,000 / 1.10 (4 times) = 27,320.54 Year 5 40,000 / 1.10 (5 times) = 24,836.85 Total present value $202,946.27 Less investment 200,000.00 Net present value $ 2,946.27 Present value index 1.015 C24 - 26 Present Value Method Assumptions: Proposals A B C Total present value $107,000 $86,400 $93,600 Total investment 100,000 80,000 90,000 Net present value $ 7,000 $ 6,400 $ 3,600 Present value index 1.07 1.08 1.04 What is the meaning of an index over 1.0? C24 - 27 Internal Rate of Return Method The internal rate of return method uses the net cash flows to determine the rate of return expected from the proposal. The following approaches may be used: Trial and Error Assume a rate of return and calculate the present value. Modify the rate of return and calculate a new present value. Continue until the present value approximates the investment cost. Computer Function Use a computer function to calculate exactly the expected rate of return. C24 - 28 Qualitative Considerations Improvements that increase competitiveness and quality are difficult to quantify. The following qualitative factors are important considerations. 1. Improve product quality? 2. Reduce defects and manufacturing cycle time? 3. Increase manufacturing flexibility? 4. Reduce inventories and need for inspection? 5. Eliminate non-value-added activities? C24 - 29 The Capital Rationing Process 1. Identify potential projects. 2. Eliminate projects that do not meet minimum cash payback or average rate of return expectations. 3. Evaluate the remaining projects, using present value methods. 4. Consider the qualitative benefits of all projects. 5. Rank the projects and allocate available funds. C24 - 30 Chapter 24 Power Notes Capital Investment Analysis This is the last slide in Chapter 24. Note: To see the topic slide, type 2 and press Enter. C24 - 31

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